Why Is Volatility So Low And What Should We Do Now?

Last week the VIX closed at one of its lowest levels in recent history. Why? And what can we do about it? In my view, there are a number of inter-related reasons why option prices and option implied volatility are so low, and they might suggest some ideas for portfolio construction.

To make sure we are using the correct terms, note that implied volatility is the volatility that is used to price an option using a formula like Black-Scholes. And this is what the VIX tries to capture. On the other hand, the actual measured volatility, which is computed using the standard deviation of returns over a prescribed horizon is termed the realized volatility. The two are connected. So, the first and most obvious reason why the VIX is so low is that realized volatility is so very low. Over the last six months, realized volatility has averaged below eight percent, so the VIX right around ten percent does not look particularly low when seen in the context of historically low realized volatility.

Second, there has been a very substantial flow into equities – retail flows last week into SPY ETFs were the largest on record. Both data and anecdotes illustrate that retail investors who have been waiting have finally decided to move into equities in a big way as they look back and see the market’s upward move despite all the prognostications of chaos from Brexit, Italy, and US and French elections, which never materialized. A rallying market generally drives volatility lower.

Third, there are a number of strategies in the markets that are all collectively what I will call “inverse volatility” strategies that have been winners and hence attracted more capital. Here are some examples. The inverse volatility ETN XIV has been a star performer since the financial crisis and has generated a few thousand percent of cumulative return with one hundred percent return just since the US elections – and it basically follows the simple strategy of selling VIX futures and “rolling down” to the spot value of the VIX. There are “volatility targeting” algorithmic strategies that look at the level of realized or implied volatility to take positions in S&P futures. When volatility falls, they increase their exposure, and when volatility rises, they reduce their exposure. There are “risk-parity” type strategies that do essentially the same, but which in addition are also driven partially by the correlation between equities and other asset classes. Finally, there are “trend-following” strategies that systematically target a specific portfolio volatility and also add to the inverse volatility crowd.

Fourth, selling options or volatility has historically been a profitable strategy for generating yield if an investor has a long enough time horizon and can hold the position through the inevitable fat tail events. In a world of very low interest rates, ease of execution, ample capital and no fat tails, this “yield enhancement” from option selling has become almost a religion. Across all asset classes, the “carry” trade is simply another form of volatility selling, and the carry trade in all back-tests looks like a persistent, structural phenomenon.

Fifth, when options are sold, the intermediate buyers of those options are Wall Street dealer desks. As the size of their books swell, and given that they cannot warehouse large amounts of risk in the current regulatory climate, they have three choices: First, they can sell those options to other buyers, further pressuring the prices of options and hence implied volatility. Second, they can sell something else, i.e. options of other expiries or on other asset classes, thus creating correlations between options in disparate markets. Finally, they can hedge the options by trading in the underlying instruments such as index futures contracts. Since having a long option position is hedged by selling the underlying instrument when it rises and buying when it falls, this locally creates a dynamic of mean-reversion, and hence of further declines in realized volatility. However, this is only locally stable. For large shocks, the mean-reversion is likely to break down.

Speaking with market participants over the last few days, a few things stand out: First, the leverage from volatility targeting funds is at all-time highs, and a sharp rise in the VIX now could result in deleveraging or selling of futures from many of the inverse volatility participants all at the same time and on all-time scales. Second, option selling has moved into shorter expiries. By some measures, close to a third of the volatility selling is in options on equity indices inside of two weeks and struck within a couple of percent of the current levels of the equity markets. This raises the question of what the dynamics are likely to be if we have a moderately sharp move in the markets in the short term with a sharp rise in volatility. It is possible that those who are long volatility liquidate their options and the markets revert to being quiet. Or, it is possible that the collective activity of the inverse volatility participants drives the markets and brings in others (trend followers, for example), thus amplifying the market moves. It is impossible to tell with certainty, since we just don’t know the balance of positions with complete accuracy and how the various market participants will behave. But we do know that the balance has shifted as the number and amounts of volatility selling activity has increased over the last few months. It has been one of the only games in town that has resulted in persistent performance and hence attracted other investors from the sidelines. For the same unit of option selling income, sellers have to sell larger and larger notionals, thus exposing themselves to market fluctuations.

All of which is to say that some care is warranted. Over a long enough holding period, the equity market tends to go up – it is a “biased coin”, since generally over a long enough horizon we should expect the S&P to track GDP. But in the short run, market ecology and increased leverage can and should result in large de-leveraging corrections. I have been trading in the options markets since 1990, and this is not the first time we have seen the dynamic we see today. In most cases historically, it has paid to replace outright risk with cheap options, or to perhaps build in some cheap downside protection, even without knowing accurately the timing of the correction. While it is almost impossible to time the corrections, it is equally unwise to be superstitiously short volatility when the dissonance between common sense and market behavior becomes so wide. When everyone begins to sing the short volatility song, something is likely to give. In Stevie Wonder’s words:

When you believe in things that you don’t understand,
Then you suffer,
Superstition ain’t the way

Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.